# Lecture 11 - 1 LECTURE LECTURE 11 EC205.01 ‐ FALL 2009...

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Unformatted text preview: 12/2/2009 1 LECTURE LECTURE 11 EC205.01 ‐ FALL 2009 ‐ ALPER 1 Outline y Use the IS ‐ LM model to analyze y Effects of shocks, y Fiscal policy, y Monetary policy y Derive the aggregate demand curve from the IS ‐ LM model y Discuss several theories about what caused the Great Depression EC205.01 ‐ FALL 2009 ‐ ALPER 2 Recall: Equilibrium in the IS ‐ LM model The IS curve represents equilibrium in the goods market. ( ) ( ) Y C Y T I r G = − + + r LM r 1 The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. The LM curve represents money market equilibrium. EC205.01 ‐ FALL 2009 ‐ ALPER 3 = − M P kY lr IS Y r 1 Y 1 12/2/2009 2 Policy analysis with the IS ‐ LM model ( ) ( ) Y C Y T I r G = − + + r LM = − M P kY lr We can use the IS ‐ LM model to analyze the effects of • fiscal policy: G and/or T • monetary policy: M EC205.01 ‐ FALL 2009 ‐ ALPER 4 IS Y r 1 Y 1 causing output & income to rise. An increase in government purchases 1. IS curve shifts right r LM r 1 ( ) Δ − G 1 by 1 b 1-t r 2 2. IS 1 EC205.01 ‐ FALL 2009 ‐ ALPER 5 Y r 1 Y 1 IS 2 Y 2 1. 2. This raises money demand, causing the interest rate to rise… 3. …which reduces investment, so the final increase in Y is smaller than 3. ( ) 1 G 1 b 1 t Δ − − The effects of fiscal policy are larger when … y LM is flatter y small k y large l y IS shifts out a lot with the increase in G y b(1 ‐ t) is large y Flatter IS y h is small ‐‐‐ little crowding out y Steeper IS y Slope of the IS curve is not a good indicator for the effectiveness of fiscal policy EC205.01 ‐ FALL 2009 ‐ ALPER 6 12/2/2009 3 Crowding out G Y ↑⇒ ↑ ( ) d M P ⇒ ↑ EC205.01 ‐ FALL 2009 ‐ ALPER 7 ( ) S but M P is fixed r I Y ⇒ ↑⇒ ↓⇒ ↓ Empirical Evidence: How important is crowding out? Multiplier using Keynesian cross only: 4.07 (i.e. the distance cd ) EC205.01 ‐ FALL 2009 ‐ ALPER 8 Study Ratio of ab to cd Adjusted Multiplier Goldfeld 0.93 0.93x4.07 = 3.79 Friedman 0.849 0.849x4.07 = 3.46 Hamburger 0.876 0.876x4.07 = 3.57 A tax cut r LM r 1 r 2 Consumers save (1 − MPC ) of the tax cut, so the initial boost in spending is smaller for Δ T than for an equal Δ G … 2. IS 1 1. EC205.01 ‐ FALL 2009 ‐ ALPER 9 Y r 1 Y 1 IS 2 Y 2 and the IS curve shifts by ( ) − Δ − T b 1 b 1-t 1. 2. …so the effects on r and Y are smaller for Δ T than for an equal Δ G . 2. 12/2/2009 4 2. …causing the Monetary policy: An increase in M 1. Δ M > 0 shifts the LM curve down (or to the right) r LM 1 r 1 LM 2 interest rate to fall IS EC205.01 ‐ FALL 2009 ‐ ALPER 10 Y Y 1 Y 2 r 2 3. …which increases investment, causing output & income to rise....
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Lecture 11 - 1 LECTURE LECTURE 11 EC205.01 ‐ FALL 2009...

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